ASC 606 Revenue Recognition Series: Identifying the Contract with the Customer (Part II)

In ASC 606: Revenue from Contracts with Customers (ASC 606), the Financial Accounting Standards Board (FASB) established a five step process for revenue recognition. The first step in this process is to identify the contract with the customer. While this may seem simple, there are many considerations that must be taken into account. FASB defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” The phrase ‘enforceable rights and obligations’ refers to what can legally be enforced; different conclusions may be reached in different legal jurisdictions.

Contracts can be established through various mediums: written, oral, or implied by an entity’s customary business practices. Implied promises are considered part of a contract under ASC 606 if the customer has a reasonable expectation, based on the vendor’s past practices that are part of what was negotiated. An example of an implied promise is the assumption that a vendor will provide support to go with a software subscription. Even if the contract doesn’t state that support will be provided, but the customer knows that the vendor customarily provides it, then the customer has a reasonable expectation that the negotiated contract also includes support.

ASC 606-10-25-1 details the five attributes an agreement needs in order to be considered a contract. They include:

• Attribute 1: The contract is approved by all parties involved and each party is committed to performing its respective obligations.
• Attribute 2: The arrangement clearly states the rights for the goods or services to be transferred.
• Attribute 3: Payment terms are identified.
• Attribute 4: The contract has commercial substance. That is, the contract has an impact on the risk, timing, or amount of the entity’s future cash flows.
• Attribute 5: The entity has determined that it will likely collect substantially all of the consideration that the contract entitles it to.

If these criteria are met at the beginning of the agreement, then the entity may conclude that the arrangement is a contract according to ASC 606, and can move to the second step of the five step process.

Attribute 1: Approved Contract

When the agreement is approved, both parties must be committed to performing their obligations in order for the arrangement to be legally enforceable. For most organizations, this likely means a signed contract. However, some entities may have alternative customary practices for approving and committing to a contract.

Termination clauses are integral in determining the contract term, or the period in which parties have to present enforceable rights and obligations. A contract does not exist if each party has the ability to terminate a wholly unperformed contract without compensating the other party. In ASC 606-10-25-4, the standard defines a ‘wholly unperformed contract’ as one that meets the following criteria:

1. None of the promised goods or services have been transferred.
2. Based on the contract, the vendor is not yet entitled to receive any consideration.

This means that even if the entity initiated work on the promised good or underlying asset, the contract would be considered wholly unperformed if it has not been delivered and the contract does not stipulate than any consideration is due. If this were the case and the agreement allowed both parties to terminate without any penalties, then it would not be considered a contract under ASC 606.

The concept of a ‘wholly unperformed contract’ could have a significant impact on contracts that permit both parties to cancel the arrangement without the other party’s approval. If they want to ensure these arrangements are recognized as contracts, they need to remove the cancellation clause or add a penalty for cancellation. The early termination fee would produce economic risk, which would be considered an ‘enforceable right or obligation.’

The standard also addresses situations where a contract exists, but the term is shorter than the stated contract term due certain cancellation clauses. For example, a customer has a right to cancel their 12 month contract after only 6 months and then again at the end of each proceeding month without penalty. The vendor does not have the ability to cancel the contract. Since only one party has the ability to cancel, the agreement meets the criteria to be considered a contract. This arrangement would be treated as a 6 month contract followed by six 1 month contracts because the contract could be terminated by the customer at any of those points in time.

Attribute 2 and 3: Identify Rights and Payment Terms 

The second attribute relates to whether the rights of each party are identifiable in the contract. Similarly, attribute three relates to whether payment terms can be identified. Both of these attributes can be satisfied through explicit contract language detailing the rights and obligations of each party as well as the billing frequency, amounts, and terms. If either of these aspects are not included in the agreement, then it would likely not be considered a contract under ASC 606.

Attribute 4: Commercial Substance

The fourth contract attribute relates to whether the arrangement has commercial substance. The standard defines commercial substance in ASC 606-10-25-1(d) as when “the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract.” This attribute helps to avoid recognizing revenue for transactions that have no economic impact or business purpose.

Attribute 5: Assess Collectability

Finally, attribute five requires the entity to evaluate whether it is probable that it will collect substantially all of the consideration it is owed for a contract. This is based on management’s evaluation of whether the customer has the ability and intention to pay the consideration in the contract, which requires a significant degree of judgement. FASB purposefully used the language ‘substantially all’ in regards to the collectability analysis because it allows entities to continue accounting for an agreement under ASC 606, even if it doesn’t expect to collect the entire contracted amount. The entity needs to believe management has the ability to pay ‘substantially all’ of the consideration when it is due.

When assessing the customer’s intent to pay the promised consideration, management should take into account all relevant qualitative and quantitative facts and circumstances. They should consider the customer’s collection history and their current financial condition. If this attribute is met at the beginning of the contract, the entity will not need to re-assess for collectability unless there is a significant change in the facts and circumstances.

How to Account for Revenue if the Contract Criteria is Not Met:

If any of the five criteria discussed above are not met, then the arrangement does not meet the definition of a contract under ASC 606 and the entity would not move on to the next four steps. There may be situations where the definition of a contract is not met, but the customer has paid consideration to the vendor. In this situation, the consideration should be recorded as deferred revenue. The vendor may only recognize revenue for the amounts collected when one of the following occurs:

1. The vendor no longer has an obligation to perform any more duties under the arrangement and substantially all of the agreed upon consideration has been collected and is nonrefundable.
2. The arrangement is terminated and the consideration received is nonrefundable.
3. A situation where all of the following is true:
   1. The consideration received is non-refundable.
   2. The good or service that the consideration relates to has been transferred to the customer.
   3. There is no further obligation under for the vendor to provide goods or services or for the customer to make payments.

Unless the arrangement subsequently meets all five contract criteria, revenue cannot be recognized for consideration received until one of the three scenarios occurs. This could produce significant delays in revenue recognition for entities that enter into agreements with customers that don’t lack one or more of the required attributes.

Combining Contracts

ASC 606 requires the entity to combine two or more contracts entered into at or near the same time with the same customer. The guidance does not provide parameters for how much time is considered near the same time; entities will have to use their own judgement when applying this rule.

The contracts should be accounted for as a single contract if any of the following criteria is met ASC 606-10-25-9:

1. Negotiations for the contracts are performed with the same commercial objective in mind.
2. The consideration in one contract is dependent on the price or performance of another contract.
3. Goods or services promised in one contract form a single performance obligation when combined with goods or services promised in another contract.

Overall, the new standard’s language allows for more flexibility in accounting for revenue recognition if a single obligation is fulfilled through two or more legal documents that are in essence pieces to the same puzzle.

Contract Modifications

A contract modification exists when the enforceable rights of the original contract have been changed or when new enforceable rights have been added. This could come in the form of changes to the consideration or changes to performance obligations.

After concluding that the contract was modified, the entity must determine how to account for it. Modifications can either be treated as a separate contract or combined with the undelivered goods or services from the original contract, effectively replacing the original contract. The modification would be accounted for as a separate contract if it meets both conditions:

1. Distinct goods or services are added to the scope of the contract.
2. The increase in price reflects the standalone selling price of the newly added distinct goods or services. This price can be adjusted for upfront costs that are not required for the additional goods or services. For example, if the original contract promised access to an online archive of educational material for 20 users for $25,000 and the modification promised access for an additional 5 users for $5,000, the entity could argue that $1,000 is the adjusted standalone selling price per user. The price is discounted from $1,250 per user because there was no setup activities required for the additional users. Under these circumstances, $1,000 would be considered the standalone selling price.

If both of these conditions are not met, the modification should be combined with the original contract and accounted for either prospectively or with a cumulative catch up entry, based on the nature of the undelivered goods or services from the original contract. The guidance provides three scenarios:

Scenario I: The undelivered goods or services in the original contract are distinct from the delivered goods or services in the original contract.

Accounting Treatment I – Prospective Treatment: Combine the undelivered goods and services from the original contract with those promised in the modification and account for them as a new contract. The contract consideration for these performance obligations should include both (a) the consideration promised in the original contract that remains unrecognized when the contract is modified, even if the amount was received but not recognized, and (b) the new consideration promised in the modification.

Scenario II: The undelivered goods or services in the original contract are not distinct, and thus, the performance obligation from the original contract is partially satisfied when the contract is modified.

Accounting Treatment II – Cumulative Catch-up:

1. Combine the partially satisfied performance obligation(s) from the original contract with the new performance obligation(s) from the modification.
2. Allocate the consideration available, including the new consideration from the modification and any consideration not yet recognized under the original contract, to the contract.
3. Determine how much revenue should be recognized for partially satisfied performance obligations. If that amount is different than revenue recorded to date on the contract, record a cumulative catch-up at the time of the modification.

Scenario III: There may be modifications where the nature of the undelivered goods or services is a combination of scenario I and II.

Accounting Treatment III – Combination: The entity would account for the effects of the modification on each undelivered good or service as proscribed by each scenario. The entity would apply a prospective method to distinct undelivered goods and services and a cumulative catch-up method to undelivered goods and services that are not distinct.

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